Monday, October 21, 2013

Via Barry Ritholtz I read the analysis of Lacy Hunt about how recent Federal Reserve policies have been a failure to lift growth. I am somehow sympathetic to the argument that Quantitative Easing has had a limited effect on GDP growth -- although one has to be careful when analyzing the effectiveness of QE by comparing it to the alternative scenario (no QE at all) rather than simply measuring the observed GDP growth. But I find that the analysis of the article is not accurate when it come to the working of central bank reserves (and I have made a similar point before). Maybe it is a matter of semantics but the way the author analyzes the relationship between reserves and the money multiplier is not consistent with the conclusions reached about the lack of effectiveness of monetary policy actions.

Let me highlight two pieces of the analysis that I have difficulty understanding. First, there is the argument that increasing the amount of Reserves (deposits of commercial banks at the central bank) not only is not helpful but can be a source of speculation and bubbles. The actual quote from the article is:

"If reserves created by LSAP (Large Scale Asset Purchases) were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition."

How can reserves be funding speculative activities if they remain in the balance sheet of the banks? Reserves represent an asset in the balance sheet of commercial banks. They have increased by having commercial banks selling other assets to the central bank. So the amount of "riskier" or "less liquid" assets must have decreased. The author suggests that what is going on is the following:

"(Banks) can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking."

Yes, banks can trade their Reserves for either bank loans to the private sector or by purchases of risky assets (stocks). But in both cases the amount of reserves has to go down. One can make the argument that the injection of liquidity is triggering one type of lending more than another but this is inconsistent with the view that the problem with QE is that banks are simply sitting on reserves without doing anything with them.

Finally, the author argues that the fall in the money multiplier is a way to see the failure of QE.

"Today the monetary base is $3.5 trillion, and M2 stands at $10.8 trillion. The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2. The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth."

The money multiplier has collapsed because the panic from the financial crisis triggered a very large increase in demand for liquidity. The money multiplier is inversely related to the demand for liquidity of households and financial institutions. In those instances, if the central bank does not increase the monetary base, the money supply will collapse with catastrophic consequences for the real economy (these were the dynamics of the Great Depression). By increasing the monetary base (QE) the central bank is ensuring that the money supply is not falling and therefore supporting growth. Reading the fall in the money multiplier as a failure of monetary policy to stimulate growth is not correct.

The rest of the article makes some good points and refers to recent academic articles that suggest that QE has not been very powerful affecting interest rates or lending and I think that some of that evidence is useful and a good starting point to debate on the effectiveness of monetary policy when interest rates are zero.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).